Will The Crisis Shake Some Deeply Rooted Investing Trees?

How should an investor price a government bond? Is the risk of repayment all that matters, or is it important to consider what the proceeds will be spent on?

Can an investor actually decide that it is ‘ok’ if a government doesn’t service its contractual obligations for a period because it’s the ‘right thing to do’?

Having worked with emerging markets in Africa, these kinds of questions are not quite as new to me as they are to the world just waking up to them during this coronavirus crisis. Unsurprisingly, they are eliciting perplexed head scratching, complex legal discussions, and philosophical references to ‘fiduciary duty’. Whilst the term ‘ESG’ floats around and all investment houses now have some kind of ESG function or funds, it is not really mainstream enough to have garnered possible answers to the above questions.

These issues have particularly struck home to me working on the concept formation of a sovereign ‘COVID-19 social bond’ in South Africa. The idea is that when you are already at the fiscal cliff edge, with a fiscal crisis brewing and little fiscal space for increased expenditure for stimulus measures, and you are then hit by an existential crisis like a pandemic, you need to crowd in cheaper funding in large size. We target issuance of ZAR100bn (or 2% of GDP) with multiple tranches. A social bond is a debt instrument where the use of proceeds generate social returns in additional to the financial return generated for holders of the debt instrument. They are different from social impact bonds, which pay out on certain social criteria being achieved.

See here for more of the technical details around this proposal for a social bond.

The question this raises is how much cheaper you can issue debt when tagged (with appropriate auditing) to health care and economic support spending only in a time of crisis?

Recent issuances by Guatemala and Ecuador showed that issuance just inside sovereign curves could be possible in large size ($550mn and $400mn, respectively) for social causes. The Guatemala bond was for COVID-related expenditure, whilst the Ecuador bond came just pre-crisis and was for social housing. Social bonds are still tiny as a segment compared with green bonds, with around $25bn issued so far this year, double three years ago.

The problem encountered with hard currency issuance is also tyranny of the benchmark. Complex social bond structures that have step up coupons on conditionality being met or not (that act as an incentive for the issue to stick with their social obligations) are index ineligible. Credit enhancement from IFIs is also ineligible for index inclusion at the moment. This creates a lot of problems for sovereigns and the World Bank group going forwards in terms of looking at effective ways of providing support to poorer countries.

Some investors are now lobbying for index rule changes as the need for credit enhancement becomes more of a norm, and these may well be forthcoming. However, the index is king for EM investors – the vast majority of money in EM debt (perhaps over 95% of the $10tn invested) is index benchmarked by our calculations. Whilst fund managers like to bemoan the fact that they are tied to an index, the fact that indices are pliable as consensus among the fund management community changes does make this a somewhat shaky defence.

Without credit enhancement, can a bond that is designated for a cause not trade inside its sovereign curve? If, with specific monitoring and evaluation audits, it is achieving specific aims (positive, social) rather than for general budgetary purposes (including wastage, other interest costs and corruption) should it not be somehow worth more? The answer a decade ago certainly would have been ‘no way’, and repayment risk would have been all that mattered. But now, as ESG thinking percolates even into vanilla investing, so there is some concession (if small) for hard currency debt. This trend may well continue.

The fundamental sticking point for now in hard currency and offshore investors is underdevelopment of the segment and mindset.

Turning to local markets, a wider range of tools and behavioural responses is available to drive lower yields onshore than offshore:

• Regulatory requirements for investors to pay due regard to ESG criteria and social return (this happened recently with a directive from the FSCA to pension trustees in South Africa).
• Patriotic investment like with war bonds – a sense you are donating your duration spread or spread above the base rate a bond is paying say for the social return of the money. In this sense, it is more capital efficient than philanthropic donation (where you lose capital and return); here you just pay away your return. This can be particularly effective when tapping retail or high net worth investment segments.
• Behavioural hooks, such as requiring banks and asset managers to market aggressively to clients or have easy opt-in pathways through online accounts for instance.
• Tax incentives, the ability to place in tax free wrappers.

South Africa is already seeing a strong level of interest in its ‘Solidarity Fund’ for donations to the coronavirus crisis, and a social bond could provide additional mechanisms to garner funding directly into government spending – side stepping issues of increasing saturation of issuance in the local market that are likely to emerge through this year.

Fiduciary duty over capital is increasingly seeing definitions flexed in times of crisis. Banks are used to this more than portfolio investors are – in normal times to extend forbearance to struggling but fundamentally credit worthy firms facing temporary shocks, and similarly in times of crisis where there are given system backstops such as guarantees, they are able to offer forbearance on a much larger scale. Our experience in this crisis dealing with policy design issues of forbearance-related guarantee schemes is that banks understand well their role as a faster and more effective deployer of stimulus if given the appropriate backstops to prevent systemic financial stability risk. The risk, of course, is that under inappropriate regulatory or political pressure this becomes destabilising in emerging markets. This can often be seen in relation to how banks treat state-owned enterprises.

The issue of fiduciary duty comes up in relation to a desire for poorer sovereigns to have a debt stand-still for this year in response to the coronavirus crisis. The G20 has backed such a move targeting $20bn of interest payments saved, Paris club official creditors are already agreeing such a stand-still, and all eyes now fall on private sector creditors like banks as well as bond holders.

Such a move for banks may well be easy, but it does raise the questions over who is getting a free ride and what long term adverse consequences such a move may have on banks’ willingness to extend bilateral credit to weaker sovereigns (either in terms of access at all, size or cost).

Private bond holders are problematic – firstly they will be bound by benchmark performance and judged against that, then they could fall foul of credit ratings marking this as a default (which it would be in contractual terms). This in turn could generate forced selling and index status loss. Add to that that fund manager in general have no way of communicating, polling, or seeking permission for doing anything – investors must instead vote with their feet based on fund manger performance. Some active managers could potentially participate but then be judged against peers who didn’t. Sovereigns could use collective action clauses (CACs) to vary terms, but such a process would likely cause significant holdout problems where there is an implied default by the backdoor and loss of present value.

Even if polling institutional investor clients or changing bond documentation was possible, processes would likely be far too lengthy and legally fraught to be of much use in the coming fiscal crunch in the next year for these sovereigns.

This is what happened last time this kind of thing was tried – in the mid early 2000s the IMF’s attempts, post Asian crisis, fizzled out given such legal and logistical blockages. A recovery from this crisis (sooner or later) will similarly take pressure off.

Just as with the ESG issues, moving away from the tyranny of the index and the yield curve, end investors becoming more aware of wider social return, indices becoming more flexible, wider definitions of fiduciary duty and the possibility the crisis rumbles on through several waves, so new thinking may well stick eventually on how debt standstills can work and how debt can be priced in crises. CACs became much more commonplace after the Greece debt restructuring and so capital market shifts and new frontier bond design, feeding into new supra-national institutional frameworks for managing such issues, could well be possible.

If everything is going to be different after this crisis, why not think outside the box?

Peter Attard Montalto is Director and head of Capital Markets Research at Intellidex – a South African research and consulting company. He advises global and local portfolio investors, corporate boards and c-suite on political economy issues in South Africa and through the rest of Sub-Saharan Africa. Currently energy policy and its interface with investors, state owned enterprises and private companies in South Africa is a major part of his focus.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)